More analysis on the situation in Greece, Denmark and North America

Just following up on yesterday’s post, I want to go into further detail regarding two situations in Europe and pivot to a Canadian-centric look at North America. All of these threads won’t tie together but I will see what I can do to bring some holistic thinking to the game!

Six and a half years after the global financial crisis, central banks in emerging and developed economies are continuing to pursue unprecedentedly activist – and unpredictable – monetary policy. How much road remains in this extraordinary journey?

In the past month alone, Australia, India, Mexico and others have cut interest rates. China has reduced reserve requirements on banks. Denmark has taken its official deposit rate into negative territory.

Even the most stability-obsessed countries have made unexpected moves. Beyond cutting interest rates, Switzerland suddenly abandoned its policy of partly pegging the franc’s value to that of the euro. A few days later, Singapore unexpectedly altered its exchange-rate regime too.

More consequential, the European Central Bank has committed to a large and relatively open-ended programme of large-scale asset purchases. The ECB acted despite a growing chorus of warnings that monetary stimulus is not sufficient to promote durable growth, and that it encourages excessive risk-taking in financial markets, which could ultimately threaten economic stability and prosperity, as it did in 2008.

Even the US Federal Reserve, which is presiding over an economy that is performing far better than its developed-world counterparts, has reiterated the need for patience when it comes to raising interest rates. This stance will be difficult to maintain, if continued robust job creation is accompanied by much-needed wage growth.

Whether accidental or deliberate, the currency wars are real and this is because we are living in a world short of aggregate demand. Even in the U.S., where El-Erian says growth is best, you have to look at Q4 at 2.6% and wonder. First, business investment was declining and I think will be revised down. Moreover, We should be trimming 2nd GDP revision expectations to below 2% annualized due to inventory changes alone (see here). That’s not robust growth. And given the weak PCE deflator, nominal GDP growth is even weaker – this from the best the lot.

What this tells you is that efforts to boost growth that are not predicated as I recalled yesterday on dealing with “income distribution and private debt overhangs” are going to lead to secular stagnation. And in the absence of fiscal policy, it means strong monetary policy offsets that weaken the currency. That’s what we’re seeing, accidental or not.

So this is the setup to understand as we talk about Greece. On Greece, I wrote about a month ago that “A lot of people have convinced themselves that contagion is not a risk and, therefore, Greece can be taken to the woodshed. I think negotiating from the belief that contagion will be minimal, limits policy choices and increases the potential for policy error and a full-blown crisis.” And I think this is what we are seeing now. As Dario Perkins told me yesterday, many policymakers in the Troika believe that, with bank exposures to Greece being minimal due to the socialization of losses onto the official sector, and with firewalls in place via QE, OMT and the ESM, Greece can be cut loose. That’s why they believe they can negotiate a hard line against Greece. I see this as reckless, however, because the outcomes here are uncertain. We don’t even know how the euro will react to a Greek default or Grexit. And uncertainty breeds negative feedback loops, moving us clearly into the tail risk segment of market outcomes.

I could go on here but what’s the point? We are in a tense negotiating stand-off. Policy error risk is high and that leads naturally into market risk. If you look at this through the fingers of instability lens that I have set out previously, it suggests negative outcomes orders of magnitude worse than standard gaussian bell curve analysis would imply – and in markets and places we cannot predict.

This is why what’s happening in Denmark is emblematic of tail risk. Here’s the 30,000 foot view. Capital has been fleeing the euro area as well as currency areas where instability reigns. Russian capital flight is an example, but so too is Greek capital flight. The carry trade is also a factor as money flees places where leverage to the oil sector is high and currencies are collapsing. At one point, this capital fled to Switzerland, causing the Swiss franc to surge. The Swiss reacted by erecting a floor through which the euro could not fall since exports to the eurozone make up more than 40% of Switzerland’s trade volume. The amount of intervention necessary to hold that floor was immense and bloated the Swiss balance sheet. They could not sustain the floor politically. And so they let their currency float. That’s the power of markets in action.

So, as soon as the Swiss dumped their de facto peg, my thinking turned to Denmark because of its peg to the euro. And apparently, hedgies were thinking the same thing as well, putting relentless pressure on that peg. Focus on the asymmetry here though. Tail risk means massive moves and so speculators are betting small amounts to benefit from this. And that makes the Danish central bank’s position untenable because it cannot go much further into negative territory. It can only print money and buy euros. Why? Because negative rates are a tax. And that is a tax that will be passed on to the domestic economy so that banks can earn a positive net interest margin. We are now seeing the limits of how far down rates can go. Here’s what the Wall Street Journal says is happening:

Denmark’s central bank, the Nationalbank, has cut rates four times since the start of the year to -0.75%. The Nationalbank is scrambling to defend the country’s long-standing peg to the euro, which has come under strain since the European Central Bank announced a large-scale bond-buying program in January, sending the common currency sharply lower.

FIH Erhvervsbank’s Mr. Nordahl said some customers have already left the bank following the decision to charge interest on deposits.

“That is the reaction we expected. It’s not a run on the bank, it’s not all clients but we have seen more activity in our customer service department than we usually have,” Mr. Nordahl said.

He added that the bank’s own analysis shows it has enough liquidity to stay solvent even if it were to lose all of its deposits.

The charges will be introduced from March 9 and could affect about 26,000 retail customers who have about 8.5 billion Danish kroner ($1.29 billion) worth of deposits in the bank. Only about 1 billion kroner of that is in day-to-day deposit accounts that will be charged with a negative interest rate of 0.5% at the end of each quarter, Mr. Nordahl said.

Other, larger Danish banks say they may charge interest to depositors if interest rates drop even further, or stay below zero for longer.

Danske Bank A/S, the country’s largest bank, may charge customers to hold their deposits if negative interest rates persist for years, said Chief Executive Officer Thomas Borgen. Danske Bank currently has no plans to charge depositors, he added.

Pär Boman, CEO of Sweden’s Svenska Handelsbanken , which also operates in Denmark, said negative interest rates are “fundamentally worrying,” but said his bank has no plans to charge customers for deposits.

“I think it would be incredibly difficult to explain to a customer that one should pay to hold money in an account,” he said.

Nordea Bank AB and Nykredit, two other lenders active in Denmark, said they have no plans to charge retail depositors. Last week, though, both banks said they would stop issuing adjustable-rate one- to three-year mortgage-backed bonds, pending the creation of an industry standard for dealing with negative rates.

Yields on Danish mortgage bonds with maturities up to three years are in negative territory. One-year mortgage bonds currently trade at negative yields of between 0.3 and 0.4 percentage point.

This is unsustainable.

On the flip side of the currency wars, you have Canada, where the currency is in freefall. The problem is the leverage to the oil sector (and the impact on consumer demand in an economy where household balance sheets are stretched). That money is fleeing to somewhere and it’s not all going into the US dollar. Now, David Rosenberg sees opportunity. He writes in the National Post that “a lot of bad news is already in the price of the loonie… This is fertile ground for those of us with a contrarian streak.” Irrespective, we are seeing frackers do re-fracking, which basically means trying to cut costs by drilling in the same well a second time. That tells you they need to cut costs but not output, given their debt burdens. And that tells me that pressure on the oil price will remain in place as oil output will not diminish quickly enough for a world in which aggregate demand growth is waning. The loonie is not going on a monster tear in these circumstances.

Going back to Mohamed El-Erian’s comments that tie all of this together, we are in a world in which countries are employing every means possible to increase growth. But I don’t see these remedies working. Tail risk is high. And that makes safe assets a compelling play, especially in the Anglo-Saxon countries. The U.S remains on top, despite its weaknesses. I prefer Australia and New Zealand as a result.

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty five years of business experience. He has also been a regular economic and financial commentator in print and on television for the past decade. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College.